Poking the housing bubble

Debate over Australian house prices is never far from the headlines. And with the Reserve Bank of Australia adopting a more sympathetic approach to the housing sector in recent months, debate about whether local house prices are dangerously high is likely to intensify.

My view since last year is that the RBA will be forced to cut the official cash rate to 2.5 per cent this year to breathe life into the long moribund housing sector – so that it can take up some of the slack from the mining investment boom. Indeed, with the Australian dollar still stubbornly high and slowly killing our trade-exposed sectors, the relatively sheltered housing sector is our “great growth hope".

But to get more home building under way, established house prices will have to rise – so that developers can eke out a profit in the face of high land purchase costs and onerous infrastructure costs imposed by local councils and state governments.

Already, there are signs that national house prices are starting to rise, led by the bellwether cities of Sydney and Melbourne, and my base-case view is that a decline in the official cash rate to 2.5 per cent would generate a 10-to-15 per cent “pop" higher in house prices by mid-2014.

Building approvals are also starting to rise, developers and home builders more confident that a bottom is in place for property prices.

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But all this begs the question: will the RBA’s efforts to kick-start a housing recovery merely inflate an already dangerously inflated house price bubble? Many international analysts remain convinced that Australian house prices are seriously overvalued, and a few excitable local economists feel the same way.

Yet interestingly, led by painstaking but so far reassuring analysis by the RBA itself, the local consensus among economists is that house prices reflect fundamentals. While I’ve generally shared this consensus view, it’s worth occasionally testing and prodding the commonly accepted arguments.

Houses swallow a bigger hunk of income

For starters, most concede that relative to household income, house prices have soared in the past few decades. In a detailed study of house prices and household income in the December quarter RBA bulletin, staff economists
Ryan Fox
and
Richard Finlay
note that in 1981-82, the median Australian house price was about $48,000. At the same time, median household income was about $15,000 – implying a house-price-to-income ratio of three.

Fast forward to 2009-10 (for which the latest estimates of survey-based household income are available), median household income has risen to $61,000 while the median dwelling prices has increased to $408,000. That implies the house price-to-income ratio has more than doubled to 6.7.

Incidentally, a similar ratio is found when comparing average house prices to average (surveyed-based) household income, as average house prices and income both tend to be about 20 per cent higher than their median counterparts.

A multiple of 6.7 appears elevated – but does this reflect a bubble, or structural shifts in supply and demand? In line with past RBA analysis, Fox and Finlay note a major cause for the rise in house prices relative to income has been a structural decline in interest rates and inflation.

Indeed, back in 1981/82 the average bank variable mortgage rate was 12.6 per cent. In 2009/10, the discounted bank variable rate (which virtually everyone gets) was 5.9 per cent. Assuming a 20 per cent deposit, my calculations suggest a first-home buyer with median household income buying a median-priced home in 1981/82 would have had to devote 34 per cent of income to paying of a standard 25-year mortgage.

In 2009/10, the same first-home buyer would need to devote 41 per cent to paying off the mortgage on a median-priced home. In other words, even allowing for the drop in interest rates, mortgage affordability was moderately worse in 2009-10 than in 1981-82.

Your home is your superior cash call

That said, the rise in mortgage costs could have reflected the greater willingness of households to pay more for their home. Due especially to rising labour-force participation, household incomes have grown faster than average worker incomes in recent decades. And if housing is a “superior good", people might be expected to devote a higher share of their budget to the services it provides as their material living standards increase. Indeed, the size and material quality of homes built has increased over time – as has the “proximity premium" for homes close to our major capital cities.

There are other reassuring signs that house prices are not in a bubble. For starters, relative to household income, national house prices have been broadly stable over the past decade – suggesting values have been sustained by slow-moving fundamentals, not speculation.

What’s more, compared to other countries, Australia’s house-price-to-income ratio does not appear badly out of line. For the purposes of consistent international comparison, the RBA uses average household income derived from the national accounts, which suggests an (average) house-price-to-income ratio of 4.5 in Australia, which is comparable to New Zealand, Canada and many European countries.

Of course, America’s house-price-to-income ratio is much lower at about two, though this is perceived to reflect the fact its population is more widely dispersed among a greater number of mid-sized cities.

International evidence from the OECD also suggests the elasticity of US housing supply to changes in price is much greater than in Australia – which helps to keep US house prices closer to construction costs.

So far so good, but the more I’ve delved into these numbers, the more questions that still arise.

Is affordability overstated?

In Australia, for example, I’ve been struck by the fact that average household income as measured by the national accounts is about 50 per cent higher than average income from household surveys – suggesting a large element of “non-cash" items, such as superannuation contributions, in the latter measure. As a result, the house-price-to-income ratio (used in RBA international comparisons and mortgage affordability measures) drops to 4.5 when using the national accounts measure of income – compared with 6.8 when using the survey-based measure of household income.

That’s a massive difference, and concerning to the degree the national accounts income measure – by including income components households can’t really use – may overstate the ability of a household to pay off a mortgage.

As for international comparisons, what’s also unclear is the extent to which national-accounts measures of income in other countries are pushed up by such non-cash items to a similar degree.

While it’s also probably true that overall mortgage affordability has not gone up by much over time, the RBA’s affordability index – which compares mortgage payments for a median- priced home as a percentage of the (national accounts) measure of average household income – likely understates outright mortgage costs.

According to the RBA measure, repayments have in recent years only been about 25 per cent of household income – whereas if we compare repayments based on median incomes and median house prices, the ratio rises to 40 per cent.

More broadly, mid-sized Australian cities are less densely populated than in Europe, and closer to those in the US, yet our house-price-to-income ratios are similar to those in Europe and higher than in America.

All up, the fact that house prices relative to income have remained so high for so long suggest they’re not about to crash any time soon. But housing costs do seem to take an onerous share of the first-home buyer budget, and I’m a bit dubious about the international comparisons that have been made to date.